Summary
In the market, an intrinsic value of a business today is determined by the cash flows discounted at the given interest rates expected to occur in the future. In other words, it denotes the present value of the future cash flow added together.
Therefore, in the case of firm A, the intrinsic value = Price-to-Earnings (PE ratio) * Net Profit after tax, where PE ratio = 15 times, Net profit after tax = $50 million. In the year 2025, intrinsic value of the firm = (15 * $50) = $750 million
Intrinsic value = 9 / (1.10)1 + 12 / (1.10)2 + 5 / (1.10) 3 + 750 / (1.10)4
= 9 / 1.1 + 12 / 1.21 + 5 / 1.331 + 750 / 1.4641
= 8.182 + 9.917 + 3.757 + 512.3
= $534.12 million
Hence the firm’s A intrinsic value = $534.12 million.
There are different methods that can be used to determine the value of a company’s shares. The Dividend Discount Model (DDM) is a technique that involves quantitative analysis to predict the worth of a firm’s stock. The approach takes the assumption that the present-day valuation is equivalent to the summation of dividends paid when discounted to the initial present value (Bao and Feng, 2018). DDM technique considers factors to be accounted for when paying dividends and the expected market returns while estimating the fair value of the commodity. DDM does not factor-in changes in the market condition in the process of valuing the stock. In simple terms, DDM is based on the concept that the business’s intrinsic value is the addition of its future dividend payments.
DDM utilizes the idea of time preference for money. The approach allows the company to estimate future earnings using the present value known to the firm.
According to DDM, future value = present value multiplied by (1 + interest rate) of a particular year. The present value = future value / (1 + interest rate). Generally, a DDM approach is effective when the expected dividends to pay in the future are known and the required return. In the case of firm A, the payments are given; therefore the estimation of the present value = d1 / (1 + r) + d2 / (1 + r) + d3 / (1 + r) + d4 / (1 + r)
Therefore, present value = future value / (1 + r )t
Where d1, d2, d3, d4 represent the dividends, r = required return and t = number of years.
The approach assumes that there is zero growth in the dividends, whereby the stock value is equal to the dividend divided by the required rate of return. There are various variants of DDM, such as the Gordon Growth Model (GGM). GGM entails dividends paid per share, the rate of growth in dividends and the required rate of return.
Based on firm A, d2 = d1 (1+0.1)
- d3 = d1 (1+0.1)2
- d4 = d1 (1+0.1)3
Using GGM, the price of each share = D / (k – g), where D = dividend of next year, k = firm A cost of capital and g is the constant growth rate of dividends.
Despite the model’s effectiveness, it has some drawbacks, such as the constant growth rate of dividends. Generally, businesses experience different sessions of success; therefore, it is difficult to maintain a steady rate of income. Similarly, if the growth rate is equal to the required rate of return, the dividend will be infinite (Hens and Schindler, 2020). The limitations make GGM be a less appropriate way to value the stock value of a company.
Alternative Methods for valuing Shares
SPM approach is an approach to valuing a company’s stock assuming the firm’s shareholders discount future dividends of the business irrespective of whether earnings are retained or paid out. It is applicable when it has either constant rates or growing dividends (Phelan, Marazzina, and Germano, 2020). The SPM formula is given as, P = (E * G / K2 ) + (D / K ), where P=value of stock, E= earnings, G= constant rate of growth, K= discount rate and D= dividend payment. The method is appropriate because it considers market conditions such as inflation and external financing that may influence constant growth rates.
Multi-Stage Dividend Discount Model
This valuation method effectively evaluates stocks that are expected to have an abnormal growth rate. For example, it can be used in cases where there is constant growth at some period, and after some time, there is an increase or decline in the rate. The approach focuses on the future value based on the initial trend that tends to be high. It, therefore, forecasts dividend earnings per share on the actual rate of growth at the begging years.
Reference List
Bao, G. and Feng, G., 2018, ‘Testing the dividend discount model in housing markets: The role of risk.’ The Journal of Real Estate Finance and Economics, 57(4), pp.677-701. Web.
Hens, T. and Schindler, N., 2020, ‘Value and patience: The value premium in a dividend-growth model with hyperbolic discounting.’ Journal of Economic Behavior & Organization, 172, pp.161-179. Web.
Phelan, C.E., Marazzina, D. and Germano, G., 2020, ‘Pricing methods for α-quantile and perpetual early exercise options based on Spitzer identities.’ Quantitative Finance, 20(6), pp.899-918. Web.